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ConTraps Part III – Contract Traps Entrepreneurs Should Avoid At All Costs

Note: This is part III of a four part series. Access part I HERE, part II HERE and part IV HERE.

As noted in parts I and II of this series, agreements with Big Dumb Companies (BDCs) can be alluring and potentially fatal. In many cases, agreements contain the promise of future riches, much like a piece of cheese in a mousetrap.

This series describes how entrepreneurs can craft company-changing agreements with BDCs, while avoiding Kiss of Death contract provisions.

In Part II of this series, I suggest that entrepreneurs seek agreements in which “what is good for the goose is good for the gander.” In other words, if the BDC insists on including a specific provision in your agreement, it should apply equally to both parties. This egalitarian mindset will result in agreements in which both parties benefit directly from the results of their relationship, either in the form of revenue or cost savings. In Sharing Means Caring, I describe specific tactics that foster and extend the longevity of such mutually advantageous relationships.

When creating such sharing relationships with a BDC, ensure that you never agree to any of the following Kiss of Death Provisions, no matter how lucrative the potential relationship may seem at the outset.

Value-Added Resellers (VARs) will often seek to obtain the largest geographic territories possible. However, only grant distribution in areas in which the VARs have a proven footprint. As they expand their business, you can expand the scope of their territory.

In the early stages of your adVenture, it may be difficult to obtain tier-one distribution partners. Thus, you may initially be forced to establish relationships with smaller VARs with limited, regional coverage.

Although necessary, “stepping stone” approach of initially utilizing smaller VARs to enter new geographic markets can become problematic as your business grows, because large VARs often demand uncontested, broad, multi-country coverage. Avoid this potential conflict by reserving the right to terminate regional distribution agreements in the event that you subsequently enter into a pan-country distribution agreement. In some instances, it will be appropriate to grandfather ongoing payments due regional distributors for their past performance. Rewarding the small VARs for working with you when the larger distributers would not is the Bro thing to do.

Do Not Relinquish Joint Intellectual Property Rights

Intellectual Property (IP) provisions should ensure that both parties maintain the IP rights that they respectively own at the outset of the relationship. This is generally a straightforward and uncontested provision.

A more complicated negotiating point involves IP that is created in the course of the parties’ collaboration. Any such “joint IP” should be equally and severely co-owned and each party should retain the rights to utilize the joint IP in any fashion they deem appropriate. The BDC will generally agree to such a provision, even though there is typically little they can do with such incremental inventions in isolation, as they will likely be based upon your underlying IP.

Guard against a preclusion that would deny you from utilizing the IP developed during the course of executing the agreement. Craft terms which ensure you will not beholden to the BDC with respect to your ability to subsequently deploy and profit from jointly developed technology.

Once your development team begins working with the BDC, do not allow the BDC to unilaterally create any meaningful IP without your team’s involvement. If the BDC iterates on your technology and devises novel IP without your involvement, you risk your IP becoming subsumed by the BDC’s technological advances. Such unilateral development should be explicitly precluded in the agreement if you anticipate that this is a material risk.

Do Not Execute an Ambiguous Statement of Work

The Statement of Work defines the specific actions and responsibilities to be carried out by each party in the fulfillment of their responsibilities covered by the agreement. It should be codified as part of the definitive agreement in the form of an Exhibit.

In most cases, your tech team (not the BDC’s) will do most of the heavy lifting and will bring the majority of the technological value to the relationship. In order to optimally manage your limited resources, clearly specify the work to be performed, who will perform it and when each significant task must be completed.

The Statement of Work should include a Non-Recurring Engineering (NRE) budget that estimates the resources required to complete each major milestone. If the NRE budget is exceeded and the reason for such overages are due to the actions or inactions of the BDC, the agreement should stipulate the scope of your compensation (e.g., $250 per hour, plus materials and associated out-of-pocket expenses).

As articulated in Corporate Venturing, a risk in jointly developing and/or integrating technology with a BDC is that your company’s primary mission can be inadvertently hijacked. To ensure that the BDC judiciously uses your resources, assign a relatively high cost to your engineering personnel’s time. By establishing an NRE budget upfront, the BDC will know how many “free” NRE hours are included per the agreement and what it will cost them when they invariably ask you to expand the scope of the project.

You will generally be pleased to expand the scope of BDC partnerships. However, contractually ensure that any such expansions are at your sole discretion. If you allow the BDC to unilaterally expand the scope of your involvement, you have effectively abdicated control over your technological resources. A detailed NRE budget will help you avoid becoming the BDC’s adjunct, outsourced engineering team.

If you do not assign a price tag to your engineers’ time, an aggressive BDC could quickly consume all of your technical resources, precluding you from executing other technical initiatives. You cannot afford to consolidate your development efforts on a single relationship, no matter how lucrative it may appear at the outset. The risk and associated opportunity cost of a single relationship failing is too high and could potentially lead to the demise of your adVenture. Underestimate this risk at your peril.

Do Not Agree to Bundling Without a Minimum Price

Bundling deals can be attractive, as your product and/or technology can potentially reach a large audience by piggybacking on the reputation and market share of the BDC’s established brand. To ensure that such bundling is financially worthwhile, negotiate a de facto minimum per unit price.

A BDC will often encourage you to accept a percentage of the price they charge the end-user for your technology. If you fail to negotiate a minimum price, the BDC may prove that they are not so dumb after all and give your product away as a loss-leader to induce sales of their product(s). Without a minimum price, you could be paid a percentage of nothing, or next to nothing, depending on the price the BDC charges its end-users. Since you cannot control your partner’s end-user pricing, you must specify the minimum amount that you will be paid (per unit, per month, whatever is most appropriate to the relationship).

Do Not Grant Most Favored Nations Status

Many BDCs relish this onerous provision. A Most-Favored Nations (MFN) clause essentially states that, “Mr. Little Company can never do a similar deal with anyone, under any circumstances that is better than the deal cut with the BDC.” Clearly, this is the sort of provision that a savvy entrepreneur will never fall prey.

The path of your adVenture is far too unpredictable to anticipate the nature and scope of every future opportunity, as made clear by the examples cited in Optimistically Pessimistic. As such, your goal when negotiating a MFN clause is to maximize your flexibility and keep as many future options open as possible.

The MFN provision is a slippery slope and often a tripwire to a lawsuit. Do everything you can to avoid granting it. I have crafted hundreds of agreements and I have only agreed to this provision, in a highly-watered down form, in a handful of instances. Although it may require tenacity, you can generally negotiate this provision away, even if the BDC tells you, “We always get this provision.” My response to such BDC nonsense is, “Great, I love doing things differently. This poses an interesting challenge, but I am confident we can devise a reasonable alternative that addresses your underlying concerns.”

One way to denude this provision is to wrap caveats around the term “similar” and to liberally use the word “substantially.” For instance, you might propose something to the effect of, “Startup X agrees to not enter into an agreement, with a like-sized partner, which grants substantially lower pricing, given that such partner agrees to substantially similar volume commitments.”

Do Not Issue Unmitigated Exclusivity

Unmitigated exclusivity can be the death knell of a small company. It is often alluring, as it is generally granted in exchange for upfront cash and/or the promise of a significant, future relationship. However, if given the chance, the BDC may put your technology on the shelf, either as a competitive reaction to remove your technology from the market or, more commonly, because they become distracted and lose focus once they realize your technology cannot be deployed by their competitors. For this reason, exclusivity at a startup is more aptly termed Excludesivity, as it guarantees your adVenture will be excluded from leveraging future opportunities.

See Part IV of this series – for an in-depth discussion regarding how you can effectively negotiate this most heinous ConTraptual provision.

If you abide by the suggestions outlined in this ConTraptual series, the resulting mutually advantageous agreements will ensure that you can eat your fill of cheese without having to perpetually fear that an unforeseen trap will suddenly break your company’s back.

John Greathouse

John Greathouse is a Partner at Rincon Venture Partners, a venture capital firm investing in early stage, web-based businesses. Previously, John co-founded RevUpNet, a performance-based online marketing agency sold to Coull. During the prior twenty years, he held senior executive positions with several successful startups, spearheading transactions that generated more than $350 million of shareholder value, including an IPO and a multi-hundred-million-dollar acquisition.

John is a CPA and holds an M.B.A. from the Wharton School. He is a member of the University of California at Santa Barbara’s Faculty where he teaches several entrepreneurial courses.

Note: All of my advice in this blog is that of a layman. I am not a lawyer and I never played one on TV. You should always assess the veracity of any third-party advice that might have far-reaching implications (be it legal, accounting, personnel, tax or otherwise) with your trusted professional of choice.